Chapter 7- Related Parties – Compensation and Loans to Officers 121 Chapter 7- Related Parties – Compensation and Loans to Officers Reasonable comp Loans vs Capital contributions to S Corps

An individual lends a $1,000,000 to his S Corp An individual lends a $1,000,000 to his S Corp. He then takes no salary but has the Corp pay his personal expenses? This is a disaster. I hope he set it up as a contribution of capital rather than a loan. He better have set this up as a loan. This guy got lucky. Better to set it up as a loan but this guy did get lucky. Scott Singer Installations – Item H. page 129.

The S Corp Compensation 121 The S Corp Compensation Several cases where the taxpayers were advancing funds to S Corps, taking repayments and not taking salary. The question is it better to lend the money or treat it as a capital contribution. PATAP

The S Corp Compensation 122 The S Corp Compensation Glass Blocks Unlimited, TC Memo 2013-180 Finding distributions from the corp. were wages to the president/ shareholder. During a down turn owner the only full-time employee ended up transferring funds to his corporation. This issue was is this a loan or a capital contribution. Factors court looked at are on page 122. PATAP

The S Corp Compensation 122 The S Corp Compensation Glass Blocks Unlimited, TC Memo 2013-180 Finding distributions from the corp. were wages to the president/ shareholder. No wages were paid but loan repayments were made at the shareholder’s request. Court ruled that the transfers were capital contributions not loans. Distributions were dependent on the success of the business rather than on an unconditional payment? Taxpayer provided 100% of the personal services to the business. PATAP

The S Corp Compensation 129 The S Corp Compensation Compare to the Singer Installation Case on page 129. From 2006-2011 singer advanced $1,160,343 Advances recorded on the books as loans For audit years 2010-2011, the S Corp paid personal expenses of $181,872.- these were recorded as repayments of loans on its books and tax returns. No payments were treated as wages or salary subject to employment taxes. PATAP

The S Corp Compensation 129 The S Corp Compensation Singer Installations Case page 129 IRS wanted to reclassify all payments as “compensation”. PATAP

The S Corp Compensation 129 The S Corp Compensation Singer Installations Case page 129 Court findings: 2006-2008 advances of $646,443.- reasonable to categorize as loans when the company was profitable. 2008-2011 advances considered as capital contributions. Years that the business was struggling. Court indicated that the taxpayer had sufficient outstanding balances and repayments were correctly identified as loans. PATAP

The S Corp Compensation 129 The S Corp Compensation Singer Installations Case page 129 IRS disagreed with findings in Action on Decision -AOD 2017-04 Court failed to determine if payments to Mr. Singer’s creditors were for services. The court focused in on the debtor creditor relationship and did not analyze or cite relevant statutory or regulatory provisions governing wages. PATAP

The S Corp Compensation 129 The S Corp Compensation IRS disagreed with findings in Action on Decision -AOD 2017-04 While the Service may recognize a payment from a corporation to its shareholder-officer who is also an employee as a loan repayment, the taxpayer must provide objective evidence that both substantiates that a bona fide loan exists between the parties and substantiates that the payment from the taxpayer to the employee was specifically in repayment of that loan and is separate from compensation paid to the employee for the performance of services f or the taxpayer. PATAP

The S Corp Loans Vs Capital- My take 129 The S Corp Loans Vs Capital- My take Loans especially well documented loans with scheduled repayments better than contributions for this issue. Loans repayments are not discretionary Should be properly documented Chances of being sustained as a loan are better if the company has a repayment capability. Chances of being sustained if there are others providing services in the business. PATAP

The S Corp Loans Vs Capital- My take 129 The S Corp Loans Vs Capital- My take Be careful with structuring transfers of money to losing C Corps. Defaulted loans will be treated as either: Personal bad debt, or Employee business bad debt- Misc. 2% itemized Consider issuing stock – 1244 loss treatment page 42. of the manual. PATAP

Reasonable Compensation 121 Reasonable Compensation What would an independent investor approve? Reasonable salary Industry comparison Bus. Size/ complexity Prior compensation BOD actions Div. Payments Agreement

Reasonable Compensation 121 Reasonable Compensation Services performed Receive loans or distributions Is anyone else working ? % of Ownership What would they make elsewhere Is there a formula? Compensated as less than prevailing rates. Comp. significantly different than those performing similar duties.

Income Approach- business valuation 125 IRS Methodology Three Approaches Market Approach- try to match the comp to other similar sized companies Income Approach- business valuation Cost Approach- break down the duties and apply a cost to them. Market Approach –Compare the compensation to the industry How much compensation would be paid to a non-owner in the same position?? PATAP

IRS Methodology- Market Approach Compare the taxpayer to comparable companies Median is the amount that is in the middle If you have an odd number of items it is the middle number If you have an even number of items it is the mean of the two values PATAP

Difficult to apply to small business because you need public data. Market Approach Difficult to apply to small business because you need public data. PATAP

IRS Methodology- Income Approach Time consuming Need comparable business Compare the taxpayer to comparable companies Median is the amount that is in the middle If you have an odd number of items it is the middle number If you have an even number of items it is the mean of the two values PATAP

IRS Methodology- Cost Approach 125 IRS Methodology- Cost Approach Interview the taxpayer Break down the duties Apply a rate to the duties based on comparable salaries. Most often used by small businesses Compare the taxpayer to comparable companies Median is the amount that is in the middle If you have an odd number of items it is the middle number If you have an even number of items it is the mean of the two values PATAP

Reasonable Wage Summary Better to figure this at the beginning of the year than at the beginning of the audit. Better with a reasonably high or low salary than no salary. Use resources including Bureau of Labor Statistics. http://www.bls.gov/bls/blswage.htm PATAP

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Reasonable Wage Summary My contact at Rcreports Paul S. Hamann Phone 720-833-7399 phamann@RCReports.com PATAP

Question A service S Corporation earns $2,975,928 prior to employee/owner salaries. The client asks you what is a reasonable salary. You Say: A) None- its too much work to file payroll tax returns and pay taxes. B) $125,162 C) $450,255 D)$2,000,000

Newt Gingrich Paid salary of $450,255. S income of $2,525,683. Medicare Savings -$73,244 -$98,501 in 2016

How about a $360,000 salary and $10,559,000 in S Earnings Medicare Savings $306,211 $401,242 in 2016

Watson Case- Supreme Court Declined to Review 128 Watson Case- Supreme Court Declined to Review Larson, Watson, Bartling & Eastman Partnership WATSON PC Owner Watson owned 25% of Larson, Watson, Bartling & Eastman which he contributed to an S corporation. Watson argued originally IRS didn’t have the power to change a negotiated agreement between him and the company PATAP

Watson Case- Supreme Court Declined to Review 128 Watson Case- Supreme Court Declined to Review Watson used a S Corp to be the owner of his interest in a CPA partnership. S Corp billed the partnership for services The S Corp paid: 2002 2003 CPA Firm Rev 2,349,556 2,949,739 Salary $24,000 Distributions 203,651 $175,470 Watson owned 25% of Larson, Watson, Bartling & Eastman which he contributed to an S corporation. Watson argued originally IRS didn’t have the power to change a negotiated agreement between him and the company PATAP

Watson Case- Supreme Court Declined to Review 128 Watson Case- Supreme Court Declined to Review IRS Expert AICPA Management Accounting Practice (MAP) Survey for Iowa. A owner-employee average $70,000 annually Watson’s billing rate was 33% higher than average. Reasonable Salary would be $93,000 Watson owned 25% of Larson, Watson, Bartling & Eastman which he contributed to an S corporation. Watson argued originally IRS didn’t have the power to change a negotiated agreement between him and the company PATAP

Bona Fide Debt 135 Presence of note Schedule of repayment Reasonable % is required Collateral obtained Demand for repayment Payments have been made Transaction reflected as debt by both parties Financial condition of debtor- see Shaw Case Shareholder lacks complete control Restrictions by board Corp. pays dividends Intends to pay and can pay without liquidation Collection enforced or documents amended Meaningful amounts are repaid

141 Below Market Loans C Corp Lends to Shareholder. Interest is Imputed. C Corps. Books Shareholder DR CR Interest Expense 1,000 Dividend Income DR CR Dividend 1,000 Interest Income Corporation has additional income of $1,000. Shareholder has dividend income but may or may not have an interest deduction.

141 Below Market Loans S Corp Lends to Shareholder. Interest is Imputed. S Corps. Books Shareholder DR CR Dist,or Comp 1,000 Interest Income DR CR Int. Expense 1,000 Dividend or wage Shareholder may or may not have dividend income and may or may not have interest expense deduction. Corporation has additional income of $1,000.

141 Below Market Loans Shareholder Lends to Corp. Interest is Imputed. C Corps. Books Shareholder DR CR Interest Expense 1,000 Paid In Capital DR CR Investment in Co. 1,000 Interest Income Corporation has an additional expense of $1,000. Shareholder has interest income.